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Jun 28

Eiger Pharmaceuticals: Good Data but the stock hasn’t followed

I bought Eiger Pharmaceuticals back in February at $11. As the chart below shows, its been a painful slide since then.

It is one ugly looking chart. However Eiger is not alone. Among the biotech stocks I follow there were a number that fell into a similar malaise in March or April. While the IBB (the biotech index) has held up and recently rallied hard, the smaller biotechs that are not part of the index have not done as well. However I’m seeing signs of this sentiment changing, which hopefully bodes better for the future.

Eiger’s Post-Bariatric Hypoglycemia Data

While the stock has declined, I remain of the opinion that the data Eiger has presented has been pretty good. I already discussed their Phase 2 result on lonafarnib in this April blog post. Last week they released more Phase 2 results for another drug called Exendin 9-39. Again I thought the results were positive.

Exendin 9-39 is targeting patients with post-bariatric hypoglycemia. This is a condition that occurs in some people that have undergone bariatric surgery, which is a surgery performed for weight loss. Some post-op patients become hypoglycemic after eating. That means their glucose level drops too low. Depending how severe this is it can cause all sorts of terrible outcomes, with the worst being unconsciousness and seizures.

Exendin 9-39 decreases insulin secretion. It is expected therefore that introducing Exendin 9-39 will dampen the instances of hypoglycemia in patients at risk. In December Eiger presented initial Phase 2 results, which looked at a single-dose subcutaneous (SC) injection. Those results showed that Exendin 9-39 produced the desired effect.

The results released in June were an extension of the December results (I also have a copy of the poster and will send it to anyone who emails me for it). The new data looked at two variations of the first set of results: a multiple ascending dose of the SC injection, and a multiple ascending dose of a liquid formulation of Exendin 9-39. The charts below show 3 hour glucose levels following a meal of the SC injection (left) and liquid formulation (right). These levels are compared to a baseline patient group that received nothing.

In the 60, 90 and 120 minute intervals, the patients on Exendin 9-39 had significantly better glucose levels, which is what you want to see.

After the stock reacted poorly to the data it was postulated by Daniel Ward on twitter that maybe the market didn’t like the 150-180 minute data. You can see how during this time period the baseline and Exendin arms converged to similar glucose levels. But I point out that in an earlier key opinion leaders (KOL) presentation by Eiger, the following chart (slide 28 from this presentation) shows the glucose responses of 3 patient groups: symptomatic post-bariatric hypoglycemia patients (so those that get hypoglycemic), asymptomatic post-bariatric hypoglycemia patients (those that don’t get hypoglycemic), and control persons (I believe these are just regular people that have not had a surgery). You can see that in the 150-180 minute data of the two post-bariatric patient cohorts, neither of which are on Exendin 9-39 or any other drug, the glucose levels converge in a similar fashion to what was seen in the Exendin 9-39 results.

I believe there is one other important inference that can be drawn from the above chart. Again, focusing on the red and white groups of patients who have undergone post-bariatric surgery, I can’t help but notice that the difference between a symptomatic and asymptomatic patient is really not that big.

I have to wonder how much of the market response was due to this. Folks looked at the delta in the response between the Exendin 9-39 and control group and were unimpressed with the visual difference between the two groups. What the above chart is telling you is that the expectation should not be so high. The difference between a symptomatic and asymptomatic post-bariatric patient is simply not that big. That Exendin 9-39 is producing results that appear close (maybe better?) to that of a healthy post-bariatric patient is quite positive in my opinion.

Summing it up

The stock is cheap but it’s admittedly its not the perfect set-up. At $7 the market capitalization is about $60 million. Eiger had $48 million of cash on their balance sheet at the end of the first quarter and $15 million of credit line debt. They have another $10 million more they can borrow under the credit line. Eiger burned through $11 million in the first quarter and $12 million in the fourth quarter. Before that their cash burn was in the mid-single digit millions. So bottom line they are going to have to raise cash here at some point, probably before year end.

I originally reduced my position in Eiger as it seemed to be in free fall. However after thinking about the results and drawing the conclusions above, I decided to add that stock back. This isn’t the sort of position that I am going to double down on or anything, but I think the price is succumbing to a weak market for micro-cap biotechs and lack of liquidity in the shares (it only takes a couple thousand shares to send the stock up or down 5%), not poor data, and I hate to get shaken out for that reason. The company has a bunch more data coming out before year end, though most of it will likely be in the fourth quarter. I will wait until those readouts and then reassess.

Jun 25

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TeraGo Networks: Inexpensive with Potential Upside from a Hidden Asset

The Straightpath Analog

A few years ago I owned a company named Straightpath Communications. I didn’t buy the stock directly; Straightpath was a spin-off of another company I owned called IDT. To be honest I did not even know IDT had these assets when I bought the stock.

The two assets being spun-off into Straightpath were obscure and hard to value. Neither generated any revenue. One of the assets was IP for various telecom patents. The second was license spectrum for very high frequency telecom bands.

It was not clear whether either of these assets would ever be worth anything. I don’t think investors understood them. I likely would have sold my shares immediately if it were not pointed out to me by a friend that Howard Jonas, IDT’s CEO, had put his son in charge of the business. Why would you put your son in charge of a junk business? So I thought maybe there was something there.

Straightpath did pretty well in the coming months, mostly on speculation that something might come out of one of these assets and not really because of any particular news or development that I could see. Because I did not really understand what I owned, I decided to sell the stock when it doubled. I believe I sold my shares for $15 or $20.

Flash forward 3 years and Straightpath was taken over by Verizon after a bidding war with AT&T. The price tag was $190 per share! Talk about leaving money on the table.

So why recount this depressing little tale of money not had? Because the Straightpath conclusion is relevant to a little Canadian company that owns similar high frequency spectrum licenses major metro areas through-out Canada. TeraGo Networks.

Terago’s Business

Terago Networks operates two lines of business. They provide data center services (see Cloud and Colocation services below) and they provide data and voice communications (Connectivity services below).

The business that owns the spectrum assets is the data and voice communications segment. The company offers internet access, unified communications redundancy to small and medium businesses across Canada. It does so by operating a wireless and fiber network within a number of large metropolitan areas. This is the weaker of the two businesses, as it revenues have been declining for the last couple of years.

The wireless access service they provide is in part via high frequency spectrum, for which they own the license to. TeraGo owns spectrum in the 24GHz and 38GHz range. I will give a more detailed breakdown of their spectrum assets a little later on.

A new Use Case High Frequency Spectrum

TeraGo kind of backed into ownership of this potentially valuable asset. Because the spectrum is high frequency, it has traditionally only been used for short distance communications, like fixed wireless, which is what TeraGo uses it for. TeraGo bought the spectrum to fill out their WIFI network in commercial and industrial parks so that its small business customers could have an alternative to purchasing connectivity services from a large communication services provider (CSP) like Shaw or Telus.

However because of the continuing growth in data traffic, CSPs are looking for ways of increasing their capacity for data transfer. Rather than deploying more fiber and network equipment into densely populated areas, an alternative is to leverage technology advances that have allowed for high frequency spectrums to be used for short distance mobile wireless capacity.

Take any downtown core. More office occupants are using their cell phones to watch videos and use apps. As more internet-of-things functionality takes off this will be compounded by additional data streaming from smart devices. Service providers have to add capacity to deal with the increase in traffic. One of the ways they can do this is by adding small cells, which are low powered radio access nodes that provide coverage over short distances. These small cells use the high frequency spectrum (like what Straightpath and TeraGo have licenses for) to transmit both “last mile” services to devices, and to “chain” together and relay data to base stations without the CSP’s having to lay costly fiber.

Before the Straightpath acquisition there was a lot of uncertainty about the value of high frequency spectrum. In fact there was a very high profile short-seller called Kerrisdale that wrote multiple articles (this one for example) on why Straightpath’s spectrum assets were worthless. Reading these articles in retrospect is informing. Its clear that there was a case to be made that technology limitations would make high frequency spectrum uneconomic. Nevertheless it was also clear that large telecom players were spending significant research dollars to determine whether this was the case. When Verizon bought Straightpath for such a large premium, and when both AT&T and Verizon were involved in a bidding war for the assets, it gave a very positive answer to those questions.

What this suggests to me is that in this respect TeraGo’s assets are significantly derisked from where they were a few months ago (I italicize “in this respect” because other concerns remain, as I will get to shortly). It’s the same technology up here in Canada, the same spectrum, and populated Canadian areas are going to run into the same bottlenecks that their US counterparts are.

Approval of Spectrum for Mobile

So the Straightpath acquisition derisks the technology, but there is still a hurdle remaining. The two spectrum ranges that TeraGo owns aren’t approved for mobile services in Canada. The United States is ahead of Canada, having already made approvals in July of 2016.

But Canada is moving towards approval. Innovations, Science and Economic Development Canada (ISED) released a consultation paper, “Releasing Millimetre Wave Spectrum to Support 5G”, in the last couple of weeks (the paper is dated June and I just found it a couple weeks ago so I think this is quite recent).

The paper is a first step toward getting spectrum approved for mobile services in Canada. It specifically requests for comment on the 38GHz band that TeraGo owns licenses to.

The 24Ghz spectrum, which is the other spectrum range that TeraGo owns licenses for, is not mentioned directly. This is because Canada is following the lead of the US, and there the two ranges approved so far for mobile usage are the 28GHz and 38GHz ranges:

But all is not lost for the 24GHz spectrum. The 24GHz band is one of a number of bands with an open for comment period by the FCC. Given the need for bandwidth, I wouldn’t be surprised if its approval just lags a little behind these other bands.

What will the ISED do with legacy spectrum?

So the ISED is open to restructuring the usage for 38Ghz spectrum and, as it follows the lead of the US, would presumably do the same with 24Ghz if the United States decides to open up that spectrum. But what happens to TeraGo’s legacy licenses in such a scenario?

Right now Terago is licensed for its spectrum assets until 2025. That license is currently limited to fixed use wireless (as it was, until recently, the only use case for the spectrum). In the request for comment paper the ISED addresses what they are considering. They propose two alternatives.

The first option is by far the preferable one for TeraGo. They will lose a percentage of their spectrum on any rule change but still be able to keep the majority of it, which will be suddenly much more valuable.

The second option would see little benefit to TeraGo, but also is unlikely to be implemented in my opinion. It would be complicated. Protection means that Terago gets to keep the areas that it currently uses those bandwidths for WIFI, and other carriers could purchase licenses around those fixed sites. Having a network with gaps would be messy, and the ISED admitted in a later comment that they believe it could hold back 5G development. If there is no protection, TeraGo would basically have to compete with wireless signals in their areas which would likely not be good for performance for either them or the wireless providers. I simply don’t think this second option is going to be favorably received by anyone and I think its far more likely that the first is accepted. Also, the United States has set precedent by choosing a solution along the lines of option 1 though from what I can tell they made no clawback of existing spectrum in their decision.

TeraGo’s Spectrum

TeraGo owns spectrum in both the 24Ghz and 38Ghz range. Unfortunately it appears that the most valuable spectrum lies in the 24GHz range. Below is their entire spectrum holdings. Note that MHz-POP column is simply the previous two columns multiplied together. When Straightpath was acquired, many analysts valued their assets on a MHz-POP basis.

With its $3.1 billion bid for Straightpath, Verizon paid $0.017/MHz/POP for StraightPaths spectrum assets. A similar valuation for TeraGo’s assets would value the 24GHz spectrum at $100 million and the 38GHz spectrum at $29 million. The consolidate spectrum assets, if valued at the same level as StraightPath, would be worth over $9 per share. The 38Ghz assets alone would be worth a little over $2 per share. Then you need to start discounting that based on what spectrum you think will get approved and how much TeraGo will have clawed back.

Putting it all together

Terago has 14.3 million shares outstanding. Their market capitalization is $65 million at the current stock price of $4.75. They have $9 million of cash and $39 million of debt.

The $9 per share number is exciting. Of course there is a lot of uncertainty around that number. There is uncertainty about what ruling the ISED will make, uncertainty about when and if the 24GHz spectrum will be opened up for mobile use, and uncertainty about the attractiveness of spectrum in less dense populations like Windsor and Red Deer.

While obviously the uncertainty dictates that a significant discount be made to the $9/share number, I think the optionality of this playing out in TeraGo’s favor has to be worth something, particularly given the positive momentum already seen in the US and by the ISED.

Also worth noting is that the spectrum is really only marginally related to the existing business. The data center business has no dependency on the spectrum assets. The connectivity business has some dependency, however there are ways for TeraGo to provide alternative connection services if their spectrum assets are coveted by a CSP.

Meanwhile TeraGo’s valuation is not out of line when only its existing operating businesses are considered. The company trades at 7x trailing EBITDA and 12x trailing free cash flow. One third of their revenue comes from data centers that they operate and offer all the standard compute, storage and disaster recovery services from that other data centers around the world offer. Their data center revenue is derived from 7 owned centers throughout Canada. Revenue grew at 13% in the fourth quarter of 2016 and 8.5% in the first quarter of 2017. TeraGo’s larger peers in the data center and cloud services business (most of them in the United States), trade at between 16-20x EBITDA. Shaw just sold data center assets a couple weeks ago for 16.2x EBITDA.

The connectivity business has had some setbacks, but it still generates significant cash flow and has a reasonably stable customer base. Revenue has been declining in the 8-10% range over the last year. The company has been intentionally churning its low value customers and has also had headwinds in Western Canada because of commodity prices. On the first quarter conference call management suggested that recent marketing initiatives were beginning to take hold and revenue should be expected to stabilize.

While TeraGo doesn’t break out the business costs by segments, based on the color I have gathered margins for the businesses are reasonably similar. Therefore I’m assuming in the following that I can break out costs for each segment proportionally to revenue. If I do, I get about $4 million of EBITDA from the Cloud business and $8 million of EBITDA for the connectivity business. Even assuming a low end multiple for the Cloud business (15x EBITDA) and a fairly low multiple for the Connectivity business (6x) I come up with an enterprise value of $108 million, which would value the shares at around $5.50.

Its worth noting that these multiples work favorably over time as the cloud business grows and becomes a larger part of overall revenue and EBITDA. Also, given the recurring nature of the Connectivity revenue, if the business can be stabilized I think its reasonable to assume it deserves a much higher multiple than 6x EBITDA.

The point here is that the current price arguably doesn’t cover the value of the existing businesses, let alone any spectrum value that might be hidden in the assets.

So that’s why I own the stock. There’s probably no rush on this one, so I have added when the stock has been weak. Because the ISED is in comment period, a change of the rules is still some time off. The comment period lasts until September. I would expect another 3-6 months before we hear anything back from them on the matter. The next quarter is as likely to be weak as it is strong. So its probably not a big rush to get into the stock. Nevertheless I would add more on a pullback into the mid-$4s. I am hopeful that in the next 18 months, as we see more clarity from the ISED and hopefully some movement on the 24Ghz spectrum, the market will begin to price in some of the upside from these assets.

Jun 21

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Adding to one of the few ideas that is working: Empire Industries

My portfolio has been behaving poorly over the last month and a half. I’ve had very little confidence to add to positions in the face of these headwinds. That said, one of the few positions that has bucked the trend and that I have added to is Empire Industries.

Empire reported its first quarter results at the end of May. The results were a step forward. The company had $32 million in revenue, which was up significantly from the fourth quarter but fairly consistent with the level of the previous few quarters. Gross margins of 22% were an improvement over the last few quarters, as was the EBITDA margin of a little over 9%. The gross margin number has been improving of late (they had been in the high teens up until the last couple of quarters) as the company has shifted toward manufacturing the second generation of their attractions products and moved away from custom designs. On the call management suggested that this level of margins, and maybe a little higher, would be sustainable going forward.

Along with the results the company announced the wind down of the steel fabrication business. Some of that business will be moved towards providing support for Dynamic Attractions, while the rest has been shuttered. Given that the business lost over $2 million last year and allows them to cut $1 million of overhead costs, I’m not sad to see it go.

I thought that Guy Nelson, Empire’s CEO, was particularly positive on the call. He said that the “market for our immersive attractions is growing rapidly”, the Q1 results “prepare the company for strong results in the future”, and the backlog is “indicative of how we are the supplier of choice among the world’s top theme parks”. They have “a record backlog of proposals in our pipeline” and its “safe to say that you can look forward to more contract announcements in the future”.

The big news that was announced just prior to earnings of was the $125 million four year contract announced earlier in May. This is a huge contract, much bigger than previous contracts that have been in the $30-$50 million range. They said they believed it was the biggest contract ever announced in their industry. I honestly was surprised that the stock didn’t move higher on this news.

As I already mentioned, Nelson said on the call that it was “safe to say” there would be more contracts in the future. True to his word, the company announced a $40 million USD contract with an Asian theme park operator last week. Again, the stock popped on the news, but remains more subdued than I would have anticipated.

Including both of these new contracts, the companies backlog stands at roughly $300 million (CAD).

So what does that mean? Well, at the current share price (~0.60c) Empire has a market capitalization of $40 million. Add on $25 million of debt and the total enterprise value is $65 million. For that price you get a company with trailing twelve month (TTM) revenues of $132 million, so the stock is trading at a little less than 0.5x TTM sales.

In the past you’d argue back that Empire’s businesses are low margin, so the multiple should be low. But with the wind down of the steel fabrication business and the spin-off of the hydrovac business, and with the shift to higher margin second gen products for Dynamic Attractions, this is less the case now. Gross margins for Dynamic Attractions are still low, but they are no longer mid-teens. They are now over 20% and maybe can tick even a couple of points higher as they increase their second generation business and integrate the in-house manufacturing of their remaining steel fab assets.

Moreover, revenues are likely to grow over the next couple of years. The $300 million in backlog is double its peak level over the last few years. Over that time Empire has operated Dynamic Attractions at a revenue level that has been about ~80% of backlog (Dynamic Attractions revenue has been about $100 million annually while the backlog, while volatile, has fluctuated around the $120 million level). Given that the backlog has now doubled, how much can we expect a commensurate move up in revenues?

It may have made sense for the company to trade at a low multiple when the steel business and hydrovac business were revenue drivers, when the media attraction business had lower margins and a smaller backlog and thus some uncertainty around its sustainability. But now, with a backlog of over $300 million (or more than two years of revenue at the current rate) and when it’s “safe to say” there are more contracts coming, it just doesn’t make sense to me.

So what’s it going to take to move the stock? Well I think that one thing holding back the stock is its accounts receivable. So far we haven’t seen revenue convert into cash. The company has accounts receivable of $37 million. This is actually an improvement over the 3rd quarter of 2016, when it was as high as $44 million. That means days sales outstanding is 111, which seems very high to me. It also means that the company has to maintain a lot of bank debt in order to balance their cash needs.

Also helpful would be one more contract to just put them over the top, and maybe a another quarter showing similar or hopefully even better gross margins and 10% conversion to EBITDA.

When I model out how the business could improve further, its not too difficult to see EBITDA getting to $5 million quarter. As I show below, assuming the same operating costs as the first quarter, a 15% jump in revenue (which shouldn’t be out of line given the large increase in backlog) and a couple basis point improvement in gross margins (brought on by the continuing shift to second gen products and the wind-down of the steel fab business), and you are almost there.

But we’ll see. So far there are sellers in the mid 60c range that have to be overcome before any move higher can take place. The stock has languished for years. The current price movement may simply be a function of a few legacy holders taking the opportunity to get out. Whatever the reason, I’m willing to bet that there is a reasonable chance that the stock moves higher in the coming months.

Jun 17

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New Position: Betting on a narrowing discount for NL Industries

Two weeks ago I took a position in NL Industries.

I don’t expect this position to be a long-term hold for me. There are a number of things not to like about the stock. Nevertheless the beaten up share price over the last couple of months presents a disconnect to the underlying assets that is historically large and I think has a reasonable chance of being corrected over the coming weeks and months.

NL Industries has 49 million shares outstanding. At $8 that gives it a market capitalization of $400 million. They have about $100 million of cash on the balance sheet. They have no debt, but do have a long-term liability for environmental remediation that is $115 million. These costs are associated with previously operated lead smelters and mining operations. They also have legal proceedings ongoing, which I will get to shortly.

NL Industries is a holding company that has ownership in two businesses. The first is Kronos. Kronos is a large, titanium dioxide pigment producer. NL Industries owns 30% of Kronos. Kronos used to be a wholly owned subsidiary but they have slowly divested that into the public market.

Titanium dioxide is used to create a white pigmentation in paints, plastics, and other coatings. Those that follow this blog might remember that I have previously held a position in another titanium dioxide producer, Tronox, and from that experience I learned that this is a tough business. Kronos has a 9% market share in the Titanium dioxide market worldwide.

The titanium dioxide market is quite cyclical. Kronos stock traded to as low as $3 at the trough of the last cycle, but we are now on an upswing as demand has been rising and little new production is on the horizon. The stock has risen from $12 to $18 since the beginning of the year.

The second business that NL Industries owns is CompX. Their ownership in CompX is 87%. CompX is a manufacturing company. They have a segment that manufactures locks and another that manufactures marine components. CompX has been consistently profitable and free cash flow positive for the last 3 years, but has not shown any growth over that time.

In addition NL Industries owns 14.4 million shares of Valhi, which is a related company that also owns a stake in Kronos. These shares are worth a little less than $50 million. The relationship with Valhi is complicated as Valhi in turn has 83% ownership of NL Industries. Valhi is 93% owned by the private company Contran, which is owned by the family of Harold Simmons. There are a number of interesting articles on the late Mr. Simmons and his controversial life (here and here for example).

While the ownership structure likely raises some questions about the long-term direction of the business, my thesis here is very short-term, so I am not going to dwell on it. By the time any strategic concerns are realized I should be long gone from the stock.

Getting back to the assets, neither Kronos or CompX are particularly bad businesses, but neither is either a particularly good business. Kronos is cyclical and requires large capital expenditures. CompX is in a low growth end market. I probably wouldn’t invest directly in either company.

What makes NL Industries interesting is that their stake in these businesses far exceeds the market capitalization of the stock. CompX has a market capitalization of $170 million. NL Industries has a 88% interest in them, so that is worth $150 million. Kronos has a market capitalization of $2.2 billion. The 30% ownership that NL Industries has is worth $660 million.

Thus, NL Industries has a market capitalization of about half of its underlying ownership in Kronos and CompX.

The story would be that simple, but it isn’t. There is one remaining caveat. The company has went through a number of lawsuits with respect to its production of lead based paints back in the 1980s. Almost all of these suits have been ruled in their favor. But there is one exception and that is the lawsuit brought about by the county of Santa Clara. Their suit, like all the others, alleges that NL Industries and other lead paint producers are responsible for compensation and abatement costs because they sold lead paint back before it was realized how dangerous it was. The suit is against NL Industries, Sherwin Williams and ConAgra. You can read about the details in their 10-K.

This suit has gone back and forth. The original verdict dismissed the claims, but an appeal overruled and ordered NL Industries and its counterparts to pay damages ($1.1 billion). But this ruling was not final and there is now a second appeal in process. This SeekingAlpha article outlined a few different legal opinions that expressed surprise at the second ruling and that expect it will be overturned on the next appeal. What is surprising is that at the time the lead paint was being sold, there were minimal concerns about its long-term environmental effects. It is unusual to hold a company accountable in such circumstances.

Its important to note that the lawsuit has been ongoing for some time and there hasn’t been any developments since January 2014 when the appeal overturned the original verdict. Also worth noting is that the stock did not react much at the time of the January 2014 appeal result. There is also nothing in the immediate future that will change the state of the trial. The timeline for the second appeal trial has yet to be set. My point here is that insofar that this risk should be reflected in a discount of NL Industries to its underlying assets, that discount shouldn’t be any different today than it was 3 years ago.

Keeping that in mind, when I look back at the stock price of NL Industries, Kronos, and CompX over that time, I notice that the current relative price is close to the bottom of the relative range of NL Industries. To throw out a few data points:

NL Industries trades in a range of 40-75% of the value of its underlying ownership in Kronos and CompX. Other than when the titanium dioxide industry was in the depths of a recession (in late 2015, early 2016) the stock tended to trade closer to the higher end of the range. Right now it trades at under 50%. Other times when the delta became that large, it eventually rebounded back to the 75% range. If I’m right, the stock should move back to $11 or $12, which would be a nice gain.

The risk of course is that A. the rebound does not occur this time or B. that Kronos, which is a very volatile stock, falls significantly from its current near-52-week highs. I am wary of both possibilities, and am not making this a large position for that reason. It’s a 3% position in my value portfolio. I am also not planning on holding this stock for too long – hopefully it rebounds back into the usual range and I sell for a nice profit. If it doesn’t rebound relatively quickly, I don’t plan to overstay my welcome.